While we work on a variety of state and local tax and incentive scenarios, one common thread between many of these is that the Nebraska Department of Revenue or Economic Development will often reclassify a business transaction or type of business based on its view of the economic, business, or legal reality. This can have significant and unwanted tax and incentive effects.

Some of the common examples of such reclassifications occur in the following areas:

Tangible Personal Property Versus Service (Sales & Income Tax)
A critical question for both sales and income tax purposes is whether a transaction constitutes the sale of services or tangible personal property. For many transactions, this distinction is unclear, particularly when a customer receives some tangible personal property combined with significant services.

To aid in addressing this question, in addition to some prevailing cases, the Nebraska Department of Revenue issued Rev. Rul. 1-08-6, which provides a test for making this distinction. However, the result even under the ruling can be unclear.

This reclassification most commonly affects: a) whether the transaction is subject to sales tax as the sale of tangible personal property; and b) for multistate businesses, how their income is apportioned for state income tax purposes.

Bundled Transaction (Sales Tax)
An improperly structured purchase transaction, in which a purchaser receives multiple goods or services for one, non-itemized price, can cause tax to be imposed on the purchase of otherwise nontaxable goods or services. This is known as a bundled transaction, in which the Department of Revenue reclassifies nontaxable goods or services into taxable ones.

Stock Sale Versus Asset Sale (Sales Tax, Income Tax & Property Tax)
Designing the sale of a business as the sale of assets or the sale of stock can have several significant tax effects for sales tax, income tax, and property tax purposes. Classification may be challenged or become less clear when the buyer and seller agree to an election under Internal Revenue Code Section 336(e) or 338(h)(10) to treat a stock sale as an asset sale.

This classification can affect (among other things): a) the valuation and depreciable life of personal property for property tax purposes; b) qualification of the transaction for Nebraska’s capital gains exclusion; and c) certain sales tax exemptions.

Classification as Employee Versus Independent Contractor (Incentive, Sales & Withholding Tax)
Classification of a person as an independent contractor or employee is a common question that businesses of all types must deal with. There are many tests to apply in making this distinction. For example, the IRS has announced a 20-factor test. The Nebraska Supreme Court has announced a 10-factor test.

This reclassification can affect (among other things): a) the state and federal tax withholdings required for a person; b) sales taxation of items produced for your business by the person or firm; and c) inclusion of the person in a company’s Nebraska incentive new job and compensation calculations.

Classification of Software Developers (Sales Tax)
The Department of Revenue will reclassify custom software developed by outside firms as a taxable sale of software, unless the software development contract meets a three-factor test for the developers to be treated as “temporary employees” of the company for sales tax purposes. This three-factor test is contained in the Department of Revenue’s Rev. Rul. 1-02-1. If a company very precisely includes the three factors for temporary employees in its software development contract, and the contract does not contain various conflicting provisions, Nebraska sales tax will not apply.

Taxation of Cloud Computing & Data Center Services (Sales Tax)
The Department of Revenue has been reviewing how cloud computing and data center services are classified and has, in multiple instances, attempted to reclassify those transactions under various theories.

First, the Department of Revenue has alleged that sales tax is due on a part of cloud computing or data center services, because those services are protected by certain levels of software security measures. In Nebraska, security services are taxable.

Second, in certain instances, the Department of Revenue has alleged that companies receiving cloud computing services are really renting tangible personal property, which if that were the case would make the transaction taxable.

Use of Step Transaction Doctrine to Treat Multiple Transactions as One
The Department of Revenue, like many taxing agencies including the Internal Revenue Service, has increasingly been using the step transaction doctrine to reclassify a series of transactions as one transaction for tax purposes. This denies the business the expected result from the series of transactions and can result in significantly negative tax implications. The U.S. Tax Court has explained this doctrine as follows:

“The step transaction doctrine generally applies in cases where a taxpayer seeks to get from point A to point D and does so stopping in between at points B and C. The whole purpose of the unnecessary stops is to achieve tax consequences
differing from those which a direct path from A to D would have produced. In such a situation, courts are not bound by the twisted path taken by the taxpayer, and the intervening stops may be disregarded or rearranged.”

The potential for reclassification under the Step Transaction Doctrine, like other doctrines such as Substance Over Form, Economic Substance, Sham Transaction, and Business Purpose, need to be understood (and planned for) at the time of the transaction and deployed or defended against in the audit or appeal.

Classification of Software as Tangible or Intangible Property (Incentives)
Following the Nebraska Supreme Court decision in First Data Corp. v. Department of Revenue, the purchase of certain software may be classified and qualify for incentives under Nebraska’s incentive programs as the purchase of tangible property. To qualify, the license contract with the software provider must meet certain specific requirements, including that the business receives a nonexclusive license in the software.

The Department of Revenue will still attempt to reclassify software from being qualified tangible property to ineligible intangible property. In so doing, it’s important to properly apply federal income tax law and properly respect key parts of the contract between the business and software provider.

Classification of Business Activity (Tax & Incentives)
Nebraska’s tax and incentive laws allow for benefits to certain types of qualified businesses. Nebraska law generally has specific definitions for the types of qualified businesses, which may not line up to the way the business views itself and which can result in a reclassification to a less favorable type of business. For example, to qualify as a manufacturer, very specific rules must be met regarding the actions that the business performs upon the final product. This means that some businesses that view themselves as manufacturers may not be manufacturers for tax or incentive purposes, as the
Departments of Revenue and/or Economic Development may attempt to reclassify the business as performing another activity.

Defending against this reclassification requires a detailed understanding of the business model and precise explanation of the model to the Departments of Revenue and/or Economic Development.

Classification as Compensation or Dividends (Incentives & Income Tax)
Those who have worked on federal income tax audits and appeals are familiar with IRS efforts to reclassify dividends and reasonable compensation in closely held corporation situations. The same reclassification can be applied by the Nebraska Department of Revenue in addressing the amount of compensation for incentive job credits and in addressing compensation income tax deductions versus dividend distributions.

Classification as Compensation or Dividends (Unemployment Tax)
Classification of ownership distributions as wages for unemployment tax purposes illustrates another dividend versus compensation reclassification. The Nebraska Department of Labor (DOL) recently mailed a letter to all limited liability companies (LLCs) and limited liability partnerships (LLPs) in Nebraska, reminding them of their requirement to pay Nebraska unemployment tax on the distributions to LLC members and LLP partners that constitute wages for Nebraska unemployment tax purposes, resulting in a potential reclassification. Under a Nebraska DOL regulation, a distribution of a share of the profits to a member of an LLC or partner in an LLP will be reclassified as wages if one of three conditions are met:

1. The distribution exceeds the proportion of the total paid in capital investment of the LLC or LLP owned by the
   recipient.
2. The distribution is made based upon the number of hours, days, weeks, or months the individual performed services.
3. The distribution is made primarily based upon services performed for the LLC or LLP. Many LLCs and LLPs have not treated such distributions as wages, but the Nebraska DOL’s regulation effectively reclassifies the payments as wages—at least for Nebraska unemployment tax purposes. This highlights a common reclassification by taxing agencies— converting ownership distributions to wages and vice versa. To avoid this reclassification, the rules regarding distributions need to be understood and precisely applied to ensure that a payment will have its intended tax result.

Classification as a Resident or Nonresident (Income Tax)
While you may believe you have left Nebraska and become a Nebraska “nonresident,” the Nebraska Department of Revenue aggressively applies its multifactor test to find otherwise and reclassify you as a Nebraska resident. It has taken several cases to court in recent years.

Conclusion
Avoiding each of these reclassifications by the Departments of Revenue, Economic Development, and Labor requires a thoughtful application of the facts of each transaction or business to a detailed understanding of the applicable law, whether that is statutory, regulatory, or case law. The first step is for an advisor to be sure that he or she understands the applicable facts, issues, and legal standards and the potential contentions that each department could make in attempting to reclassify. The second step is to ensure the legal documentation properly exists to support the intended result.